Governments face the constant challenge of allocating limited resources to an infinite number of needs. Cost-Benefit Analysis (CBA) is a systematic process for calculating and comparing the benefits and costs of a project to determine whether it is a sound investment.
Step 1: Identify All Costs and Benefits
This is the most critical step. We must identify all potential impacts of the project, both positive and negative, and for all members of society. For a new highway, costs include not just construction and maintenance, but also noise pollution and loss of green space. Benefits include not just reduced travel time for drivers, but also increased commerce and potentially faster emergency response times.
Step 2: Monetize Everything
This is where CBA becomes challenging and controversial. To compare different impacts, we must assign a monetary value to them. The cost of steel is easy to measure. But what is the value of saving 20 minutes of travel time? What is the cost of increased air pollution? Economists use various techniques, such as contingent valuation (surveys) or hedonic pricing (how property values are affected), to estimate these non-market values.
Step 3: Account for Time with Discounting
A benefit received today is worth more than a benefit received in 20 years. A cost paid today is more burdensome than one paid in the future. We use a "social discount rate" to convert all future costs and benefits into their present-day value. This allows us to compare projects with different timelines on an equal footing.
Step 4: Calculate Net Present Value (NPV)
The final step is to sum up all the discounted benefits and subtract all the discounted costs. The result is the Net Present Value (NPV). If the NPV is positive, the project's benefits outweigh its costs, and it is considered a worthwhile investment for society. When comparing multiple projects, the one with the highest NPV is generally preferred.
CBA is not a perfect science. The process of monetizing non-market goods and choosing a discount rate involves assumptions. However, it provides a transparent and structured framework for decision-making. It forces policymakers to explicitly state their assumptions and consider all impacts, leading to more rational and justifiable public investments.